–“While I don’t think blame is necessarily the right concept here, I have been arguing that low real interest rates have worked to raise real commodity prices through a number of channels. Each of these channels could be called “speculation,” if speculation is defined as behavior based on expectations of future prices. A number of commentators, including Don Kohn and Paul Krugman, have argued that low interest rates and speculation cannot be the sources of the problem, because oil inventories are low. It is true that low interest rates, other things equal, should in theory increase firms’ desire to hold inventories.

We are talking about relatively integrated world markets, however, so it is world inventories that should matter most. According to the International Energy Agency’s Oil Market Report, oil inventories held in developed countries have been above average during most of the last year, as the next graph shows. OECD oil inventories above long-run average. They rose sharply in January 2008, which happens to be the month when the very aggressive cuts in US interest rates took place. These numbers are far from conclusive, but still…”

— “So here are two questions: Are speculators mainly, or even largely, responsible for high oil prices? And if they aren’t, why have so many commentators insisted, year after year, that there’s an oil bubble?

The only way speculation can have a persistent effect on oil prices, then, is if it leads to physical hoarding — an increase in private inventories of black gunk. This actually happened in the late 1970s, when the effects of disrupted Iranian supply were amplified by widespread panic stockpiling.

But it hasn’t happened this time: all through the period of the alleged bubble, inventories have remained at more or less normal levels. This tells us that the rise in oil prices isn’t the result of runaway speculation; it’s the result of fundamental factors, mainly the growing difficulty of finding oil and the rapid growth of emerging economies like China. The rise in oil prices these past few years had to happen to keep demand growth from exceeding supply growth.

Saying that high-priced oil isn’t a bubble doesn’t mean that oil prices will never decline. I wouldn’t be shocked if a pullback in demand, driven by delayed effects of high prices, sends the price of crude back below $100 for a while. But it does mean that speculators aren’t at the heart of the story.”

— “Yet the evidence suggests that, to the contrary, the rising price is beginning to curb demand and increase supply, just as the textbooks say it should.

Those who see speculators as the culprits point to the emergence of oil and other commodities as a popular asset class, alongside stocks, bonds and property. Ever more investors are piling into the oil markets, the argument runs, pushing up the price as they do so. The number of transactions involving oil futures on the New York Mercantile Exchange (NYMEX), the biggest market for oil, has almost tripled since 2004. That neatly mirrors a tripling of the price of oil over the same period.

But Jeffrey Harris, the chief economist of the Commodity Futures Trading Commission (CFTC), which regulates NYMEX and other American commodities exchanges, does not see any evidence that the growth of speculation in oil has caused the price to rise. Rising prices, after all, might have been stimulating the growing investment, rather than the other way around. There is no clear correlation between increased speculation and higher prices in commodities markets in general. Despite a continuing flow of investment in nickel, for example, its price has fallen by half over the past year….

…Mr Harris of the CFTC, for one, believes that the oil price is still a function of supply and demand. For the past few years, the world’s production capacity has grown only sluggishly. Meanwhile, demand, especially from the developing world, has been growing faster. So there is hardly any slack in the system. Only Saudi Arabia and the United Arab Emirates are thought to be able to increase their output from today’s levels, and even then, there are doubts, since Saudi Arabia, in particular, is secretive about the state of its oil industry….

….Meanwhile, the high price is clearly beginning to crimp demand. The growth in global consumption last year was barely a quarter what it was in 2004 (see chart); this year, it is likely be even lower. In rich countries (or at least among the members of the Organisation for Economic Co-operation and Development (OECD), a rough proxy), the effect is even more pronounced. Consumption has been falling for the past two and a half years….

….In the short run, neither demand for nor supply of oil is very elastic. It takes time for people to replace their old guzzlers with more fuel-efficient cars, or to switch to jobs with shorter commutes, or to move closer to public transport. By the same token, it can take ten years or more to develop an oilfield after its discovery—and that does not include the time firms need to bolster their exploration units….”

–” In the rest of the world, however, soaring oil prices have had little traction on demand. In many countries outside of the OECD, first time car buyers have no memory of past gasoline prices, and by virtue of car ownership, now have a claim on the world’s rapidly shrinking oil reserves. The extent to which prices ration limited supply over the next five years depends to a significant degree on how much oil will be diverted from world oil markets to meet the consumption needs of major oil exporters themselves. Last year, OPEC together with independent producers Russia and Mexico, consumed over 13 mn bbl/day of oil, constituting, next to the US, the second-largest oil market in the world.

For the most part, soaring rates of domestic fuel consumption, particularly in OPEC countries, can be traced to egregiously low pump prices. Gasoline in the 25-cents/gal range in Venezuela and in the 50-60 cents/gal range in Saudi Arabia, Kuwait and Iran, have not, surprisingly, spurred enormous fuel appetites in those countries….

…With production faltering, soaring rates of domestic fuel consumption will soon cannibalize export capacity. Exports from OPEC, Russia and Mexico are expected to decline by 2.5 mn bbl/day in the next five years (Chart 6). To a large extent, that has already happened in OPEC, whose export growth has slowed dramatically in recent years. Soaring Russian exports had effectively filled the void created by OPEC, but now, as we recently heard from Russia’s resources minister, both Russian production and exports are set to decline….

…The more oil is consumed in oil-producing countries, the less oil will be consumed in the OECD. Since oil-producing countries effectively have first call on their own oil, the balance is the residual which the price mechanism must ration. Boosted by the explosive growth in oil consumption in oil-producing countries, we expect that by 2012, consumption in the rest of the world will exceed OECD consumption, a virtually unthinkable prospect a little over a decade ago, when consumption outside of the OECD measured little more than half of the OECD’s annual oil intake.”

— ” … we have reviewed a number of theories as to what has produced the current high price of oil, including commodity price speculation, strong world demand, time delays or geological limitations on increasing production, OPEC monopoly pricing, and an increasingly important contribution of the scarcity rent. Rather than think of these as competing hypotheses, one possibility is that there is an element of truth to all of them.”

Unquestionably the two key features in any account are a decrease in the price elasticity of demand and the strong growth in demand from China, the Middle East, and other newly industrialized economies. These twin facts explain the initial strong pressure on prices that may have triggered commodity speculation in the first place. Speculation could have edged producers like Saudi Arabia into the discovery that small production declines could increase current revenues and may be in their long run interests as well. And the strong demand may have moved us into a regime in which scarcity rents, while negligible in 1997, are now
an important permanent factor in the price of petroleum. Notwithstanding, different emphases among these explanations would produce profoundly different predictions as to what will happen next. If speculation and short-run price inelasticity are the key driving factors, we would expect shortly to see potentially dramatic moves downward in price. The scarcity rent, by contrast, is expected to increase, not decrease, over time.”